First, I hope everyone that reads this article is safe when it comes to their daily lives. What we are seeing on TV and online is terrible on so many levels. It seems like the heinous act of one person has brought out a lot of real-life monsters. We have seen pockets of morality and courage during this time, by protestors, by police officers, by the average citizen that tries to stand up to those that are taking advantage of the moment. May we all show morality and courage during this time when we need to be a positive counterweight to the reprehensible behavior of those that want to steal, kill, damage and destroy.
The rest of this article is on distressed assets and how to think about them right now. Buying a distressed asset is not being a bad person taking advantage of another’s situation. An asset that is not performing, if it is purchased and sustained by another owner, is a positive. Often times, owners of distressed assets did not manage their asset properly during the good times. They either over-leveraged themselves to buy the asset or they failed to save enough cash during the good times to manage through the bad times. Or sometimes the seller just wants to move on to something else – this is often the case when the distressed asset is owned by a large institutional investor. When the price of a good asset becomes cheap because of a shift in the economy it is a good idea to try to invest in some of those good assets that you would want to own. In 2010 I bought a bank-owned property that was in bad shape and in great need of repair. I bought it, fixed it up, moved my family in, and enjoyed several years of being part of the community. I also made a profit when I sold the home but both community and investor benefited in this situation.
Okay, enough of my philosophical waxing. Here we go:
The United States economy is starting to re-open but people are still uncertain how quickly or effectively the re-open will be over the coming quarters. Uncertainty still persists due to questions that, for the time being, remain open:
- Once the restrictions are lifted how many people will choose to remain on the sidelines?
- Will businesses re-engage and hire people back or has too much permanent damage been done to see a strong recovery over the coming quarters?
- How will consumers and states react if the number of infections sees a strong tick upwards after re-opening?
- Will consumer demand come out of the gates strong or will we have to wait until a more permanent solution, like a vaccine, helps people feel safe to get back to pre-COVID activities?
- What happens to consumer confidence if we see vaccine candidates fail over the coming quarters?
- How does the civil unrest that is unfolding impact the economic recovery?
During these times of uncertainty and when economic setbacks have occurred you generally have several asset classes that become distressed over time. This basically means the assets are unable to generate enough cash to pay their expenses (including debt service) and certain owners of these assets begin to sell the assets at a discount. Or the bank that takes over the assets from the prior owners sells them at a discount. Assets can include things like businesses, real estate properties, corporate debt, etc.
It can be scary to invest in distressed assets while there is a lot of uncertainty but that is when you find assets that are being sold at a meaningful discount. If you buy too early and with too little in reserve then you might become the distressed seller but if you buy and have enough patience and capital than more often than not you will see significant returns over the next 3-10 years.
The chart below shows investor returns by the year invested. You can see that investors that invested in 2009, 2010, and 2011, when things were still very much uncertain regarding how the United States would come out of the Great Recession of 2009, were massive compared to later years when people invested after a lot of the uncertainty had been removed.
Today, there are a lot of asset classes that are distressed or on the verge of becoming distressed. Some currently distressed asset classes include:
- Hospitality (e.g., hotels)
- Entertainment (e.g., movie theatres, airlines, cruise lines)
- Retail (e.g. retailers and retail properties)
- Energy (e.g. oil companies and those supporting oil companies)
There are also some asset classes that may become distressed over the coming months:
- Small businesses (already distressed but likely to be further distressed after government funds dry up)
- Offices (e.g., office properties after underlying businesses stop renewing their leases)
- Single-Family Homes (foreclosures will likely rise if unemployment persists and people stop receiving compensation from the government and foreclosures are allowed to happen again)
Some of these assets have already seen their prices go down substantially, some of these assets will see further price deterioration over the coming quarters, and some have seen some price recovery over the past month.
As an investor, if you wait until all of the uncertainty is removed then you will lose out on the best opportunities and those massive returns will likely be gobbled up by someone else. However, if you jump in at the wrong time and in the wrong way you could lose a significant part of your investment.
Remember, there is greater risk to these investments but also potentially greater return.
What are you to do?
Step 1: Figure out what asset class you want to invest in and how you can invest in it
For me, I have decided I want to invest in the hospitality sector when it comes to distressed assets. Why? I think people will want to travel again and when things turn around people will want to get out and have experiences. They may stay more regional for the next few years to avoid extensive air travel but they will go on vacation and businesses will still require some degree of travel to some that will increase over time. It is a matter of when and not if people will stay in hotels again. Also, poorly capitalized competitors like individual owners of Airbnb and VRBO properties are going to be damaged more than the well-capitalized hotels.
Since I know I want to invest in hotels the next logical step for me is to ask how I can invest in these opportunities when they become available. There are only four logical options – and for me there are only really two possibilities.
- Purchase a distressed hotel property: Not a real option for me. I cannot afford the price tag and even if I could I would not want to place a great deal of my capital into one investment.
- Purchase hotel debt that is in default: There is a lot that goes into buying distressed debt, including foreclosure laws that vary state-by-state. The only way I do this is as an investor in a fund that is run by people that know how to buy distressed debt.
- Purchase discounted hotel stocks: This is easy to do and to analyze so this a real option for me and most average investors.
- Purchase a distressed hotel property through a syndicated deal: Real estate crowdfunding makes this a real option for me. In fact, one of my favorite platforms has a distressed hotel investment that it is offering to investors this week. I may not invest in this specific investment but these platforms should make these types of opportunities accessible to people like you and me.
Step 2: Discover the opportunities, analyze them, and make a decision on when to invest.
Below is how I plan to analyze opportunities in the hotel sector that are available via publicly traded stocks or syndicated private investment funds. No matter what asset class you decide to invest in the criteria below should be something you consider when buying distressed assets. The overarching keys are as follows:
- Buy an asset that had a bright future before March 2020.
- Have enough cash in reserves to weather a slow economic recovery.
- Invest with people that have done it before.
Here is a little more detail on how I analyze potential opportunities.
Publicly traded companies
Okay, for me the public stock market is one option to discover opportunities in the hotel industry. I need to analyze the universe of hotel stocks trading at a discount, pick the best companies relative to their price based on some rational criteria, and then finally make a decision when to invest in the best opportunities. For me, I consider the following when investing in distressed stocks:
- Discount to pre-stressed levels: You can look at how the stocks were trading before the market crashed in March. This will give you how much they are trading below their recent pre-COVID 19 levels.
- Strength of Balance Sheet: We do not know how long it is going to take to get back to a pre-COVID 19 economy so a priority for me is to invest in those companies that can financially manage through a downturn that lasts longer than most people expect. As an example, most people feel hotel occupancy will return to normal levels in 2-3 years. However, what if it takes longer or the recovery is minimal during 2021. The company I choose to invest in will have enough liquidity to survive even if the recovery takes longer than anticipated.
- Quality of Portfolio: How strong will this business be after the dust settles and things get back to normal? I want to invest in the business that had a bright future before COVID-19 and has a bright future afterwards. You do not want to invest in the asset that was struggling even before the shit storm that hit.
- Management Track Record: As I have stated beforehand, you have a great opportunity to learn about the company and management of publicly traded companies by listening to their earnings calls. Listen to the calls or read the transcripts so you can understand the quality of management. All else being equal, you want to invest in best-in-class management when things like timing of a recovery remain uncertain.
Investing in distressed assets through a syndicated deal
Real estate crowdfunding has made investing in specific properties that I could not otherwise afford a real option for me and other average investors that do not have millions of dollars to place into a large distressed property. I expect a host of opportunities to become available on these crowdfunding platforms over the coming months. When they do become available, I look at the following criteria to determine if I want to invest:
- Quality of the underlying property and market: Similar to above, I want a hotel in the right location, that had solid economic fundamentals in place before COVID-19, and the long-term view of the area is positive.
- Price discount to pre-stressed valuations: You really want to understand how much of a discount you are receiving and if you are getting it at a price point that justifies the risk you are taking by putting capital into a distressed property that is obviously struggling with paying expenses including debt service. If you are going to invest here you need to understand, and make sure the sponsor can explain, what discounts are happening in the market and why he/she feels this purchase is appropriately discounted.
- Size of the reserves in place to weather continued sub-par economic conditions: I will not move forward with a transaction on a single property unless I can pencil-out (prove to myself) that the investment has adequate funds (reserves) to pay expenses for a sufficient period of time until the economy rebounds. With the hotel industry, most people feel hotels will rebound in 2-3 years. Therefore, I want to make sure that an investment I join will be able to fund at least 3 years of expenses in the event the economy is slow to recovery. If you do not make sure this is the case then your investment may become distressed while you own it and you may end up losing your investment to another buyer of distressed assets.
- Sponsor track record with these type of assets: Similar to the best-in-class management, make sure the person you are investing with has done this before and is an expert at managing the asset class you are going to invest in. If they have never bought a distressed asset or are new to this asset class (for example, this is the first hotel they will purchase) then you are asking them to learn with your money. That is probably not a great idea right now.